If you think cloud stocks are overvalued, you're not alone.

JPMorgan Chase analyst Mark Murphy slashed his ratings on a number of well-known SaaS (software-as-a-service) companies  -- Alteryx (AYX)Paycom Software (PAYC 4.44%), Twilio (TWLO 3.62%)Ceridian HCM Holding (CDAY -0.09%)Coupa Software (COUP), and Smartsheet (SMAR 0.62%) -- arguing that investors were underestimating the impact that the economic downturn would have on them. 

Though Murphy slammed those six stocks in particular, his takeaways seemed to apply to the broader cloud software industry, where stocks have posted big gains in recent years, but have also reached lofty valuations. Among his concerns were:

  • "Crowded, high-multiple" software stocks that offered poor risk/reward balances in the current environment.
  • Near-term bookings are likely to decline, and the duration of the decline could be longer than expected.
  • That "the magnitude and suddenness of recent economic indicators" including rising unemployment, are being underestimated; this would impact payroll-related stocks like Paycom and Ceridian. 
A digital image of a cloud

Image source: Getty Images.

The stocks above barely flinched at the downgrades, a sign that investors believe that the SaaS sector will be among the most durable during the coronavirus crisis. Some in the category are even benefiting from the stay-at-home protocols that remain in place across most of the country. Zoom Video Communication, Okta, and Shopify have all hit all-time highs in recent days, and other cloud stocks have bounced back aggressively from recent lows.

As you can see from the chart below, all six of the stocks Murphy downgraded outperformed the S&P 500 during the last few weeks.

^SPX Chart

^SPX data by YCharts

Other warning signs

There are a number of other indicators that even top performers in the tech sector may be headed for a period of slower growth. 

Over the five weeks between March 9 and April 6, the total number of job openings listed on company-rating site Glassdoor fell by 20.5%, and white-collar industries including tech weren't exempt from that decline. Tech job listings fell by 20.2%, and have likely declined further since then as enterprise-software companies anticipate cuts in business expenditures among their clientele. 

According to CNBC, tech titan Google has cut its marketing budget by half for the second half of the year, along with other budget cuts, and is imposing a hiring freeze as its struggles with the sharp decline in ad revenue that naturally resulted from the implosion of the consumer-facing economy. Last year, the company spent $18.5 billion on sales and marketing. 

What does it mean for cloud stocks?

A large percentage of cloud stocks continue to trade at lofty valuations, and four of the six stocks Murphy downgraded have price-to-sales ratios above 15, meaning the sector is vulnerable to some short-term pain. Business spending on things like software tends to slide later in the economic downturn cycle. Consumer-facing companies usually get hit first, and the pullback in consumer spending eventually hits corporate businesses as their clientele make necessary spending cuts, or even fail. Given how rapidly the economy has been sinking and how sharp the shock to employment and consumer spending has been, the cycle could move faster this time. Google's decision to slash marketing spending by billions of dollars, and the significant slide in tech job postings show that this downturn is already having an impact on the sector.

However, over the long term, these stocks should bounce back. This isn't a sector that is being leapfrogged, nor is it being disrupted by the shutdowns in a similar way to, for example, brick-and-mortar retail. The pandemic isn't directly impacting software spending. These companies were growing fast before the crisis, and they should return to healthy growth in a stronger economy.

Investors considering opening positions in SaaS stocks will want to look for companies with competitive advantages, leadership in their respective niches, high growth. Another excellent sign is strong dollar-based net retention -- which simply means that the business is holding on to its customers and getting them to spend more each year.

The software sector won't be immune from the economic crisis now underway, and its high valuations could take a hit. But if you're a long-term investor, there's little need to change your approach to these stocks even as they brace for a recession.